Joel Greenblatt is one of the most prominent figures in value investing, with a career that highlights his ability to identify undervalued stocks using a disciplined and systematic approach. Known for his books like “The Little Book That Beats the Market” and “You Can Be a Stock Market Genius,” Greenblatt’s philosophy revolves around finding companies that are temporarily undervalued by the market but have solid fundamentals. I've read and his re-read his books multiple times and each time, I find new insights (and more sentences to highlight). I highly recommend you pick up a copy today! Or, at least watch this talk by him. His investment strategy is rooted in value investing principles that trace back to Benjamin Graham, the father of value investing.

Greenblatt's focus on identifying companies selling below their intrinsic value (specifically, below their liquidation value in this case) empowers individual investors to capitalize on mispricings. By doing so, he offers a path to beating the market, especially when traditional institutional investors struggle due to their dependence on large, popular stocks that are closely analyzed and efficiently priced.

Methodology: How to Identify Undervalued Stocks

In a research article that Greenblatt, alongside Richard Pzena and Bruce L. Newberg, published in 1981, he applies a methodology derived from Benjamin Graham’s classic value investing approach. The key idea is to find stocks trading below their liquidation value. Liquidation value is essentially the value that would be recovered if a company were to sell off its assets, pay off its liabilities, and close down. The formula for liquidation value typically involves:

Current Assets – such as cash, accounts receivable, and inventory.

Current Liabilities – short-term debts like accounts payable.

Long-Term Liabilities – like loans and capitalized leases.

Preferred Stock – a claim on corporate assets before common stock.

Outstanding Shares – used to calculate liquidation value per share.

The key assumption in Greenblatt’s analysis is that stocks selling below liquidation value have a built-in margin of safety. This means that even if the company does not perform well operationally, the value of its assets provides a backstop to the downside risk. For example, if a stock is selling for less than the value of its assets, an investor has limited downside but significant upside if the company recovers or improves.

The study screens for stocks based on three core factors:

Price to Liquidation Value (P/L ratio below 1.0)

Price-to-Earnings Ratio (P/E ratio below a specified limit)

Dividend requirements (stocks may or may not pay dividends)

By focusing on these metrics, the authors designed four portfolios, each with varying degrees of strictness on P/L ratios and P/E ratios. Stocks that did not meet these thresholds were excluded, and only those that fit the criteria of being undervalued were purchased.

Investment Results

The study tracked four portfolios over various time periods from 1972 to 1978, each showing impressive performance compared to the broader market. The results were as follows:

Portfolio 1: This portfolio required a P/L ratio of less than 1.0, no P/E limit, and no dividend restrictions. It returned 20.0% annually before taxes and commissions, significantly outperforming the market’s return of 1.3% during the same period.

Portfolio 2: This portfolio added a stricter requirement, where the P/L ratio had to be less than 0.85. It yielded a 27.1% annual return, which still outperformed the broader market.

Portfolio 3: By tightening both the P/L ratio (less than 1.0) and the P/E ratio (less than 5.0), the portfolio generated a 32.2% annualized return, before taxes and commissions, making it one of the most successful screens.

Portfolio 4: The most stringent screen, requiring a P/L ratio below 0.85 and a P/E ratio below 5.0, resulted in a 42.2% annualized return before taxes and commissions. Even after accounting for taxes and commissions, this portfolio’s performance was substantially higher than the market.

Advice for Individual Investors

For individual investors, the key takeaway from this article is the importance of sticking to disciplined, data-driven strategies. The methodology employed here demonstrates that by following fundamental financial metrics such as liquidation value and P/E ratios, an investor can systematically outperform the market. However, patience and the ability to resist speculative market trends are crucial.

Here’s how individual investors can apply Greenblatt’s approach:

Focus on Undervalued Stocks: Look for companies that are selling below their liquidation value, as these offer limited downside risk and strong upside potential.

Stay Disciplined: This strategy requires a commitment to following financial data rather than getting caught up in market noise or speculative trends.

Understand the Risk-Reward Balance: While this strategy can yield higher-than-average returns, it also means buying companies that may be facing temporary challenges. However, their asset values provide a cushion against significant losses.

Use Screens and Filters: Use financial screens to narrow down a universe of stocks based on key metrics like P/L ratio and P/E ratio, ensuring that your investments meet strict valuation criteria.

Be Patient: Value investing often requires a longer-term perspective. The market may take time to recognize the value of undervalued stocks, so it’s essential to be patient and not panic during short-term market volatility.

Joel Greenblatt’s work with this study reiterates his broader investment philosophy: by focusing on undervalued, fundamentally strong stocks, individual investors can achieve significant returns, even outperforming institutional players. The key is to remain disciplined and stick to value-based strategies that focus on tangible metrics like liquidation value and earnings. This approach may not be glamorous or trendy, but it has a proven track record of success for those willing to put in the effort to find hidden gems in the market.

Greenblatt, J. M., Pzena, R., & Newberg, B. L. (1981). How the small investor can beat the market. The Journal of Portfolio Management, 7(4), 48-52. https://doi.org/10.3905/jpm.1981.408811